Demand for Money is Not Defined by the Interest Rate - Suggestions about the IS-LM Model -

Abstract

Even if the IS-LM model is one of the backbones in the Keynesian economics, its explanation in textbooks has a few conceptual as well as expressional errors. Take the demand for money (Md) for example. Almost all textbook authors, including Keynes himself, explain that Md increases as the interest rate declines (“downward sloping”). This explanation violates the principle of “thinking at the margin,” one of the key assumptions in the modern economics. The truth is that Md determines the market interest rate through its diminishing marginal utility, not the other way around. Another trouble comes from the fact that monetary aggregates are difficult to measure due to continuous evolution in the payment methods in recent decades. As a way of circumventing the measurement issue of the money supply, most authors too simply and too clearly say that the interest rate is fixed by the central bank. Some economists even use the IS-MP model instead of the traditional IS-LM. These may not be the right cures for the technical difficulty because a theory is to be founded more upon logic than applicability. Neither may the money supply be lightly treated because the inflation rate should remain as a key macroeconomic concern. Instead, the MㆍV may replace M in the traditional models. Corrections, as suggested in this paper, of common errors in textbooks are expected to promote students’ understanding of macroeconomic ideas.